Last week we started a series on retirement planning and personal taxes, looking at the Roth Individual Retirement Account or Roth IRA.
This post will examine what a traditional IRA is, its benefits, and potential risks. We’ll also compare the two so you can make the best possible decision for your retirement savings plan.
What is a traditional IRA?
The traditional IRA is the predecessor to the Roth IRA. It started in 1974 as a way for wage earners to get a break on taxes and save for the future. So, it serves the same purpose as a Roth. And like a Roth, you can open one up at any qualified bank or brokerage, and your contribution as of 2023 can’t be over $6,500. Also, like a Roth, that number goes up to $7,500 at age 50.
When you open up a traditional IRA with a brokerage, you can choose from a wide array of investments, including mutual funds, exchange-traded funds, stocks, bonds, and CDs. You can also hold cash in them, just like a Roth.
But that’s pretty much where the broad similarities end.
The differences between a traditional and Roth IRA
Traditional IRAs are tempting because you get an immediate tax break on any wages you place in them. There’s no waiting for the tax break at the end, like with a Roth.
But all withdrawals from a traditional IRA are taxed. And unlike a Roth, you must make withdrawals starting at approximately age 72. This is called a required minimum distribution, or RMD, and they don’t exist with a Roth IRA.
Before going further, a few caveats to this age requirement are worth mentioning. If you reached age 72 on or before December 31st, 2022, you must take your RMD. However, if you do not reach age 72 by December 31st, 2022, you must take your first RMD from your traditional IRA by April 1st of the year after you reach age 73. No matter when you start taking them, RMDs erode your earning power because that money is no longer bearing interest. How much earning power is lost depends on several factors, but you can use this calculator to find out.
Since Roth IRAs don’t carry an RMD, you can leave your cash in and give it more time to grow.
There are several variables to consider when choosing between a Roth or traditional IRA, so it would be best to consult a fiduciary financial adviser first. Unless the decision is made for you. Here’s how that might happen.
Income Requirements for Roth IRAs
There are income limits for investing in a Roth IRA.
If you have a modified adjusted gross income of $153,000 or more as a single filer in 2023, then you can’t invest in one. If you are married and filing jointly, that number is $228,000 or more. With a traditional IRA, all that goes out the window, as there are no income limits. So, if your heart is set on an IRA, but your income is too high, you’ll be limited to the traditional one.
The Bottom Line
There is plenty to consider when choosing an IRA. Of course, every financial situation is different, so do plenty of research and keep your plan flexible. But one thing is certain, an IRA is a good way to reduce your tax burden and grow your nest egg so you can retire with some degree of security.